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Fiscal Policy, Deficits, and Debt
30
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
AGENDA Thurs 3/10
• Team Teaching: CH 30
– P3: Amanda, Jeyla, Joseph, Vanessa
– P5: Ms. K (yep, once again)
• On Deck: CH 31-32 (Tues)
– P3: Allan, Ezra, George
– P5: Ms. K (surprised??) • QOD #21 : Crowding Out
• Fiscal Policy & Stabilizers
• HW: Read pp 636-650 Q#2,3,4, 7, 8 (DUE Tues 3/15)
– Read pp 655-667 Q#4,5,6 (Due Thurs 3/17)
LO1 29-2
QOD #21 :Crowding Out
• Suppose that the investment demand curve in a
certain economy is such that investment declines by
$100 billion for every 1 percentage point increase in
the real interest rate.
• Also, suppose that the investment demand curve
shifts rightward by $150 billion at each real interest
rate for every 1 percentage point increase in the
expected rate of return from investment.
• If stimulus spending (an expansionary fiscal policy)
by government increases the real interest rate by 2
percentage points, but also raises the expected rate
of return on investment by 1 percentage point, how
much investment, if any, will be crowded out? LO1 30-3
QOD #21 :Crowding Out Solution
• The increase in the interest rate would reduce
investment by $200 billion (= 2 x $100 billion), but the
increased rate of return would increase investment by
$150 billion (= 1 x $150 billion), so the combined
effect of the stimulus spending would be $50 billion of
crowding out (= $200 billion – $150 billion).
LO1 30-4
Fiscal Policy
• Deliberate changes in:
•Government spending
• Taxes
• Designed to:
•Achieve full-employment
•Control inflation
•Encourage economic growth
LO1 30-5
Expansionary Fiscal Policy
• Use during a recession
• Increase government spending
•Decrease taxes
•Combination of both
•Create a deficit
LO1 30-6
Expansionary Fiscal Policy
Real GDP (billions)
Pri
ce level
AD2
AD1
$5 billion increase in spending
Full $20 billion increase in aggregate demand
AS
$490 $510
P1
LO1
Recessions
Decrease AD
30-7
Contractionary Fiscal Policy
• Use during demand-pull inflation
•Decrease government spending
• Increase taxes
•Combination of both
•Create a surplus
LO1 30-8
Contractionary Fiscal Policy
Real GDP (billions)
Pri
ce level
AD3
AD4
$3 billion initial decrease in spending
Full $12 billion decrease in aggregate demand
AS
$502 $522
P2
AD5
$510
d b
a P1
c
LO1 30-9
Policy Options: G or T?
• To expand the size of government
• If recession, then increase
government spending
• If inflation, then increase taxes
• To reduce the size of government
• If recession, then decrease taxes
• If inflation, then decrease
government spending
LO1 30-10
Built-In Stability
• Automatic stabilizers
• Taxes vary directly with GDP
• Transfers vary inversely with GDP
• Reduces severity of business
fluctuations
• Tax progressivity
•Progressive tax system
•Proportional tax system
•Regressive tax system LO2 30-11
Built-In Stability
G
T
Deficit
Surplus
GDP1 GDP2 GDP3
Real domestic output, GDP
Go
vern
men
t exp
en
dit
ure
s, G
, an
d t
ax r
even
ues,
T
LO2 30-12
Fiscal Policy: The Great Recession
• Financial market problems began in
2007
• Credit market freeze
• Pessimism spreads to the overall
economy
• Recession officially began December
2007 and lasted 18 months
LO4 30-13
Problems, Criticisms, & Complications
• Problems of Timing
•Recognition lag
•Administrative lag
•Operational lag
• Political business cycles
• Future policy reversals
• Off-setting state and local finance
• Crowding-out effect
LO4 30-14
Current Thinking on Fiscal Policy
• Let the Federal Reserve handle short-
term fluctuations
• Fiscal policy should be evaluated in
terms of long-term effects
• Use tax cuts to enhance work effort,
investment, and innovation
• Use government spending on public
capital projects
LO4 30-15
The U.S. Public Debt
• $11.9 trillion in 2009
• The accumulation of years of
federal deficits and surpluses
• Owed to the holders of U.S. securities
• Treasury bills
• Treasury notes
• Treasury bonds
•U.S. savings bonds
LO4 30-16
The U.S. Public Debt
LO4
Debt held
outside
the Federal
government
and the
Federal
Reserve:
57%
Debt held by
the Federal
government
and the
Federal
Reserve:
43%
30-17
Global Perspective
Public Sector Debt as
Percentage of GDP, 2009
Italy
Japan
Greece
Belgium
France
United States
France
Germany
United Kingdom
Spain
Netherlands
Canada
0 20 40 60 80 100
Source: Organization for Economic Cooperation and Development, OECD
LO4 30-18
The U.S. Public Debt
• Interest charges on debt
• Largest burden of the debt
• 1.3% of GDP in 2009
• False Concerns
•Bankruptcy
•Refinancing
•Taxation
•Burdening future generations
LO4 30-19
Substantive Issues
• Income distribution
• Incentives
• Foreign-owned public debt
• Crowding-out effect revisited
• Future generations
•Public investment
LO4 30-20